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About Those Cheap Boeing 737s: United Continental Doesn't Want Them

In early 2016, legacy carrier United Continental(NYSE: UAL) surprised investors by ordering 65 737-700 aircraft from Boeing(NYSE: BA). Industry analysts concluded that Boeing had offered United an extremely low price, perhaps as low as $22 million per aircraft, a 73% discount to the list price. (Discounts of around 50% are more typical.)

United Airlines ordered 65 Boeing 737-700s in the first quarter of 2016. Image source: The Motley Fool.

On Tuesday, United Continental shocked investors again. Management revealed that United no longer wants these Boeing 737s -- and that they weren't as cheap as most third-party observers had guessed, anyway.

United orders a bunch of new airplanes

United Continental ordered its 65 737-700s from Boeing in two separate transactions in January and March. CEO Oscar Munoz described the order as a necessary step to replace capacity from 50-seat regional jets that United will retire in the next few years.

The 737-700 is the smallest commercial aircraft that Boeing produces today. Naturally, it has the highest unit costs. This made the deal somewhat suspect from day one, especially because United Continental didn't have a permanent CFO at the time. A low purchase price was critical to United's decision to go with Boeing for this deal.

United did hire a new CFO over the summer, Andrew Levy. Levy had spent most of his career at Allegiant Travel, an airline that has historically been much more careful about capital spending than United. Not surprisingly, he had a different take on United's recent aircraft order relative to the existing management team.

Never mind!

In conjunction with its investor day on Tuesday, United Continental announced that it no longer wants these 737-700s. It has converted four orders to the larger -- and much more cost-efficient -- 737-800. The other 61 orders will be deferred indefinitely and converted to the new 737 MAX.

According to United's new CFO, the company simply doesn't need these planes. First, it wants to fully utilize its "scope" authority to operate up to 255 two-class regional jets in the 70-to-76-seat range. To facilitate this, United is buying 24 76-seat E175 jets in 2017, which will be operated by Republic Airlines. Those new planes could theoretically replace about 36 50-seat jets.

United wants to get rid of most of its 50-seat jets in the next three years. Image source: The Motley Fool.

Second, United Airlines has a handful of used A319s arriving in late 2016 and 2017, and options to take more later in the decade. The A319 is similar in size to the 737-700, and United probably secured very favorable lease rates for these used planes.

Third, United is working to keep its current fleet flying longer. It is also investigating options to put more seats onto each aircraft and to increase utilization. These actions will help replace the lost capacity from retiring 50-seat regional jets without requiring big capital expenditures.

The planes weren't that cheap, anyway

On Tuesday, United Continental also revealed -- indirectly -- that the 737-700s weren't going to be as cheap as the rumored bargain-basement price of $22 million.

The company stated that by indefinitely deferring 61 of the 65 orders, it will be able to reduce its 2017-2018 capital spending by $1.6 billion. This implies that United would have paid Boeing an average of a little more than $26 million per aircraft for those 737-700s over the next two years. Furthermore, that doesn't account for any deposits that United has already paid.

Thus, while these planes were heavily discounted, the average purchase price may have been close to $30 million. That also helps explain why United Continental is no longer eager to buy these planes.

No big deal for Boeing

Even if United would have paid close to $30 million for its 737-700s, Boeing was not going to make much money on this deal. In all likelihood, it offered the planes at a big discount in order to prevent any of its rivals from gaining a new foothold at one of Boeing's biggest customers.

Additionally, Boeing's management has repeatedly stressed that the company is "oversold" on the 737 for the next several years. In other words, Boeing has been relying on the fact that some airlines will be willing to defer their orders, as United just did. Even if there is now a small production gap in 2018, Boeing can probably fill it with new orders that would be at least equally profitable, if not better.

The key takeaway is that losing these orders won't hurt Boeing much, if at all. Still, investors should keep an eye on Boeing's 737 orders over the next month and a half. If more orders for current-generation 737s show up, it will provide some extra comfort that Boeing will be able to stick to its production growth plans.

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